May 11, 2010

Taking Aim at Banks’ Operations

Arkansas Sen. Blanche Lincoln has managed to get a proposal into the financial-overhaul bill that effectively could force banks to spin off their derivatives-trading business. Since the provision doesn’t appear to have broad Democrat support, it may yet die. But it has gotten this far and, at the very least, it shows that lawmakers are open to provisions that could have a radical impact on large banks’ derivatives portfolios.

Taxpayers need to ask: Would the Blanche amendment actually protect them? And the question for bank stock investors: What would it do to the earnings and capital positions of banks with large derivatives books, like J.P. Morgan Chase?

On the first, it is important to understand how the amendment works. It effectively says banks that retain their derivatives business would no longer qualify for two critical sources of government support: federal deposit insurance and assistance from the Federal Reserve. That threat would persuade practically all banks to spin off swaps-trading businesses.

The taxpayer might get most protection in a full divestment that leaves the bank with no control over the swaps business. A truly independent entity would have to raise a lot of capital to persuade counterparties of its credit-worthiness, making it less likely to require a bailout.

However, the amendment just may prompt banks to turn swaps businesses into owned affiliates. Under that scenario, they likely would retain strong ties to the parent. During the recent credit crunch, for example, large banks receiving government aid decided to support entities that investors thought were separate. Think Citigroup and its structured-investment vehicles.
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As for the financial impact on the banks, they haven’t given any real guidance, even when asked to supply some during recent first-quarter conference calls. J.P. Morgan Chief Executive James Dimon did say that derivatives legislation could put a dent in annual revenue by “several hundred million to a couple of billion dollars.” And Mr. Dimon’s estimate didn’t take into account the potential impact of the Blanche amendment.

One big cost would be capitalizing any new derivatives entities. The Securities Industry and Financial Markets Association, a bank industry group opposed to the spinoff provision, said establishing “nonbank affiliates” could require $250 billion of capital. That seems high, given that it is equivalent to just under half the combined Tier 1 capital for the top five derivatives-trading banks.

Whatever the true number, one of the reasons to support tougher financial legislation is that over-the-counter derivatives can allow banks to hold insufficient capital for the bets they are making. Other provisions in overhaul legislation are designed to stop that. But in terms of simplicity, a key ingredient for regulatory effectiveness, they pale in comparison to the Blanche bill.